Tag Archives: derivatives

The indefatigable Brad DeLong has devoted his energies to singlehandedly protecting Larry Summers from the Internet (although, he makes pains to say, he likes Janet Yellen almost as much). Although I’m letting most of the Fed chair sideline debate pass me by, DeLong and others have raised one issue that played an important symbolic role in 13 Bankersand, more generally, the historical background to the financial crisis: Brooksley Born’s proposal to think about regulating OTC derivatives in 1998.

For those who don’t know the story, it basically goes like this. Born, as chair of the CFTC, was worried about the risk posed by OTC derivatives, which were effectively unregulated at the time. On May 7, 1998, the CFTC issued a “concept release” asking for comments about the regulation of OTC derivatives. Summers, then deputy treasury secretary, along with Treasury Secretary Robert Rubin, Fed Chair Alan Greenspan, and SEC Chair Arthur Levitt, opposed Born, and they issued their own press release on the same day opposing the CFTC. Over the next several months they successfully blocked the CFTC from regulating OTC derivatives, convincing Congress to stop the CFTC from moving forward, a position that was enshrined in statute in the Commodity Futures Modernization Act of 2000.

This guest post is by Ilya Podolyako, member of the Yale Law School Class of 2009 and a friend of mine. Ilya led the Progressive Economic Policy reading group with me and served as an adjunct professor of law at DePaul University this past spring.

One of the key provisions of the Dodd-Frank Act is Title VII, which requires all non-exempt derivatives transactions to go through a central clearinghouse (this report provides a good summary). As James and Simon have explained, the Dodd-Frank Act uses the term “swap” as a big basket that captures most financial products that we would normally call derivatives: options, repos, credit default swaps, currency swaps, interest rate swaps, etc.

Prior to the passage of the Act, most of these products were sold over-the-counter by certain large institutions. That is, in form, a transaction where you wanted to buy a credit default swap triggered by some event (say, the bankruptcy of Ford Automotive) resembled a trip to the car dealership. The dealer had inventory on the lot; this inventory was split into several different models / types of product; individual instances of a given model were relatively homogenous and varied mostly by color and minor adornments (spoilers, leather seats, etc.). If you were looking for a car of a given make and model that had certain extra features, a dealer might be able to get one custom-built for you at the factory, but you’d have to wait for the item and pay extra. Of course, the salesperson would not be able to accommodate all requests – if you show up to your average Chevy dealership and ask to buy a jet-powered car, you are likely to leave empty-handed no matter how much money you have, even though a few other individuals have been able to procure said exotic item.

This guest post is contributed by Jane D’Arista, a research associate at the Political Economy Research Institute at the University of Massachusetts, Amherst, and co-coordinator of its Economists’ Committee for Stable, Accountable, Fair, and Efficient Financial Reform (SAFER). She has taught in graduate economics programs at several universities and served on committee staffs of the U.S. House of Representatives.

Dominated by the world’s largest banks, the over-the-counter (OTC) derivatives market has been expanding since the break-down of the Bretton Woods Agreement in the early 1970s privatized the international monetary system by shifting the payments process from central banks to commercial banks. The proliferation of foreign exchange forwards and swaps that followed set in motion an ever-expanding menu of exotic instruments that reached a nominal value of over $600 trillion by the middle of the current decade. Central banks and financial regulators ignored the implications of the growth of this market and ignored warnings from the Bank for International Settlements (BIS) and the International Monetary Fund (IMF) from 2002 forward that OTC derivatives were at the center of what had become a global casino in which the largest international institutions were the biggest speculators.

The large, international institutions that created the OTC market for foreign exchange forwards and swaps were commercial banks. Following established banking practice, they conducted their derivatives business like portfolio lenders rather than broker/dealers, buying and selling forwards and swaps outside of established markets. But OTC derivatives contracts can’t be classified as assets or liabilities until they are settled and can’t be held on banks’ balance sheets the way loans and deposits are held. Instead, they were booked off balance sheet as contingent liabilities. The market structure that emerged in what came to be the largest market in the global economy was one in which non-tradable contracts were bought by and sold to customers without real time information on volume or pricing or the aggregate positions of the dealers themselves. Moreover, the fact that the contracts were illiquid required constant hedging by dealers that expanded their positions and inflated the size of the market relative to all other national and international financial markets. Meanwhile, the commercial bank dealers’ derivatives business was operating with all the implicit guarantees and subsidies that governments put in place to protect this core financial sector. In 2008, those guarantees became explicit and were exercised.

The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here). Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.

It’s about time. Yesterday, by a vote of 96 – 0, the U.S. Senate passed a ground-breaking amendment to the financial reform bill. Introduced by Senator Bernie Sanders of Vermont, this amendment would require an audit of all emergency actions taken by the Federal Reserve since December 1, 2007. In addition, the amendment mandates that by December 1, 2010, the Fed reveal those who received $2 trillion in zero or near zero interest Fed loans and what those institutions did with the money.

This was the second recent “yes we can” show of bipartisanship. Last week, by a 96 -1 vote, the Senate approved an amendment introduced by Senator Barbara Boxer of California. The Senator described its purpose was to “protect taxpayers” through the creation of an “orderly process to liquidate failing financial firms and ensure that Wall Street pays to clean up its own messes.” Whether the amendment can live up to that promise is a good question. The answer depends less upon government intervention once a firm nears collapse and far more upon government prevention of the excesses that lead both to widespread failure and government support.

First Bill Clinton said he got bad advice from Robert Rubin on derivatives. Then a Clinton adviser issued a statement essentially taking it back and blaming Alan Greenspan. (Jennifer Taub discussed some of the substantive issues on this blog.) Dan Froomkin asked Rubin, who said, “I thought we should regulate derivatives; I thought so when I was at Goldman Sachs and I thought so afterwards.” But Froomkin points out that Rubin was part of the team that suppressed Brooksley Born’s attempt to regulate derivatives back in 1998.

Brad DeLong defends Rubin, although it seems like a somewhat lukewarm defense. DeLong’s point #3 is: “Brooksley Born and her organization are the wrong people to regulate derivatives.” (That’s a statement of Rubin”s thinking at the time.) Norman Carleton, a Treasury official at the time, also defends Rubin with two posts on his blog that spell out DeLong’s point #3. In the first post, he says that Rubin favored regulation but was concerned with giving the CFTC jurisdiction over the OTC derivatives market. In the second, he explains the issue (legal certainty of existing contracts, something I don’t really want to get into here, so go read the argument there) and concludes with this logically plausible but somewhat bizarre argument:

“Rubin had proposed to Born that, instead of the CFTC asking questions about the need for regulation of the OTC derivatives market, the President’s Working Group on Financial Markets issue the questions. Born point blank refused this suggestion, thus pushing Rubin into Greenspan’s camp, much to the relief of ISDA and other Wall Street groups lobbying on this issue. They knew they had a problem with Rubin.

“Brooksley Born was so sure she was right in her legal position that she could not compromise in face of the practical and political realities. While, not to make too fine a point about it, she has been proven right and Greenspan wrong about the dangers of the OTC derivatives market, Greenspan was the better politician. History might have been different if Born had agreed to Rubin’s suggestion.”

The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here). Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.

Considering that much of the disastrous deregulation of the U.S. financial system occurred on President Bill Clinton’s watch, I was encouraged by his televised confessional Sunday. He admitted to Jake Tapper that he was led astray by two of his secretaries of the treasury, Robert Rubin and Lawrence Summers.

What an important and timely revelation. Admitting we have a problem is the first step to recovery. With financial rehab next up on the Senate’s agenda, it’s useful that someone is discrediting those who persist in promoting failed ideas. What to do about the $450 trillion (notional) over-the-counter (OTC) derivatives market will be at the top of the agenda. This is about big money. Really big. Industry began lobbying last year to protect the annual $35 billion haul that just five US banks bring in trading derivative contracts.

Reform ideas range from the most sensible recommendation by Professor Lynn Stout (return to a regime where naked credit default swaps are not enforceable), to Senator Blanche Lincoln’s very strong amendment (prohibiting the banks that have access to the Fed’s discount window from trading derivatives), to the necessary but insufficient (mandating all standard derivatives be cleared on exchanges and requiring collateral to be posted), to the weak (the current Senate bill, rife with exceptions).

Remember, this market includes potent credit default swaps, a key ingredient to the crisis. The existence of this $60 trillion (now $45 trillion) notional value market, protecting and connecting counterparties across the system, led to a $180 billion taxpapayer-funded bailout of AIG. And, as we have just learned, CDS played a central role inside the synthetic Abacus 2007-AC1 vehicle, a device that helped Goldman Sachs rob purchasers to pay Paulson.

Yet, in spite of the power of Clinton’s admission, or perhaps because of it, just after the interview with Tapper, Clinton counselor Doug Band swiftly dispatched a disclaimer. In a moment of blatant grade inflation, Band said that Clinton believed Rubin and Summers provided “excellent advice on the economy and the financial system.”

Robert Litan of Brookings wrote a paper on the derivatives dealers’ club — the small group of large banks that control most of the market for certain types of derivatives, notably credit default swaps. It’s a blunt analysis of how these banks can and will impede derivatives reform in order to maintain their dominant market position and the rents that flow from it.

I haven’t had time to do it justice, so I recommend Mike Konczal’s analysis in parts one and two (but particularly one). As Konczal says, “In case you weren’t sure if you’ve heard anyone directly lay out the case on how the market and political concentration in the United States banking sector hurts consumers and increases systemic risk through both political pressures and anticompetitive levels of control of the institutions of the market, now you have.”